Market Expert Benjamin Wey on Identifying Sound U.S. Listed Chines Companies


Emerging markets mean high-return opportunities to both investors and small businesses with one big obstacle: risk. That risk comes from the difficulty to achieve the same level of research and intelligence needed of a foreign company that you would expect of a company on your own soil prior to investing. A company’s inventory turnover, potential for growth, and regulation compliance are just three areas that an investor should be knowledgeable of prior to investing.

The fundamentals of a business and more importantly, the integrity of a management team determine its stock performance over the long run. Can lawyers and accountants give investors assessment on the integrity of a company’s management team? The answer is “No.”

As an investor, when weighing risk and identifying China-based opportunity, consider the following.

“Face Time” & Cultural Knowledge

Face time is important. This means travelling to the emerging market and meeting with C-suite executives and business leaders to gain insightful knowledge to your target industry. For example, an investor interested in an opportunity in the Chinese market must utilize people who can speak to the business leaders in the same Chinese language and with the same Chinese culture to truly understand them and their business. To read into the “minds and hearts” of a Chinese CEO and to conduct “human” due diligence is to gain facts that are far more real and extensive than any desktop accounting or legal reviews. Get to know the people that are involved.

Peter Siris, a New York based Chinese-English bilingual money manager at Guerilla Capital who has invested in many U.S. listed China based companies, describes the concept well in one of his interviews noting, “Most people who own these China stocks don’t go to China, they don’t know these companies, and they don’t speak the language. And so they can be suckered in both long and short.”

To illustrate cultural communication as it relates to risk-management, please consider the following example: At one point in time, Rino International (“RINO”) was a magnet to some investors; some investors that would take a significant loss. In 2009, it was discovered from several senior executives at large Chinese steel mills at the time that steel mills were not at all motivated to cut waste gas emissions. The reason: Those efforts would cost money and the steel industry itself was already suffering significant losses – so why add to them?

However, steel mills must meet certain minimal emission reduction standards or face large fines. As a result, steel mills spent just enough on pollution control equipment to meet regulations, but not a penny more. Pollution control equipment providers, such as RINO’s operating business in China, were likely to have a much smaller market size than the one that they portrayed publicly. After taking a look at the already crowded industry, it was also unlikely that RINO would be as profitable as it claimed to be. In addition, conversations with the local government officials confirmed the view that RINO was already running low on cash. To prevent an early demise, RINO was in a hurry to raise $100 million in an equity offering in 2009. In late 2010, RINO was subpoenaed by the SEC and its stock was swiftly delisted by the NASDAQ citing accounting concerns at the company as its reason. RINO’s corporate structure is in the form of a Variable Interest Entity – “VIE”, created by highly “creative” lawyers.

The Reality of Reverse Mergers vs. IPOs

Some investors choose companies that became public through IPOs over those that did so as a reverse merger. However, in reality, it makes no difference whether company went public through and IPO or a reverse merger; they are reviewed by the SEC in the same manner as soon as the finance registration statement, the SEC Form S-1, is submitted to the SEC. NYSE and the NASDAQ did not pass our due diligence checks either, with more than half of them having gone public through an IPO. Some investors prefer public companies that have gone public through IPOs. But the reality is that it makes no difference whether the company went public through an IPO or a reverse merger – they go through the exact same level of SEC reviews when a financing related registration statement SEC Form S-1 is submitted to the SEC.

In my view, there are a number of companies that became public through the IPO process on the NYSE and NASDAQ that do not have my investment confidence, just as there are reverse mergers that do not. That said the majority of China based, U.S. stock exchange listed companies are compelling opportunities for investors to tap into the growth of China. While there are and have been problematic companies, that small percentage should not be seen as representative of the whole.


To best protect the U.S. investing public and give them as much protection they receive when investing in U.S. companies as they do in China, there are structural changes that need to be made.

The Danger of China-based Companies with VIE structures in U.S. markets

In a VIE structure, the public shareholders do not own the underlying assets in the operating entity – the actual business that generates revenues and earnings for common shareholders. Instead, all of the sales and incomes reported by the public company and filed with the SEC are booked through contractual agreements whereby a company’s management and founders agree to transfer their rights to sales and incomes from the operating business to the public company. The original founders retain the ownerships of the underlying tangible hard assets such as cash, factories, land use rights, machinery, customers etc. In theory and in reality, company management and founders can choose to walk away and leave the public shareholders with no legal claims to the assets of an operating entity. Doesn’t this sound crazy? It certainly does.

RINO was a good example of a VIE structure. RINO’s market capitalization was at one time approaching $1 billion. Shareholders that bought shares in RINO apparently did not realize the inherent risks involved since they perhaps did not bother to read the company’s SEC filings which disclosed risks associated with a VIE deal structure.

In our view, a public company in the U.S. with a VIE structure poses the single biggest risk to U.S. investors. Alarmingly, companies with the VIE structure represent more than 20% of the entire universe of China based, U.S. listed companies listed on U.S. stock exchanges, including almost all of the high flying internet stocks. The vast majority of them have become public companies in the U.S. through IPOS.

In contrast, China’s own domestic stock exchanges do NOT permit listing of any company whose revenues are organized under a VIE structure. The VIE structure was created by global law firms in the early 2000s to intentionally circumvent legal requirements in China that prohibit foreigners from owning shares in China based internet companies. That law is still applicable in China today. However, the “creative” VIE structure has become a main stream listing process for China based companies – with almost all of them listed through IPOs in the U.S. markets. What do shareholders own by buying shares of a company organized under a VIE structure? Legal professionals may argue that shareholders get sufficient protection through those management contracts. The reality is, in today’s China, a VIE structure is nothing but a piece of paper evidencing certain “right” that is next to impossible to enforce under Chinese laws. At New York Global Group, we avoid companies with VIE structures completely.

The Guise of Companies under “Earnings Make Good Provisions”

The typical audience of early investors in U.S. listed China based companies are small hedge funds, those with less than $100 million under management and are never long term holders. The vast majorities of them are unwilling to or are unable to perform much due diligence on the target companies in China. A popular mechanism that caters to these types of investors is created by Wall Street bankers and lawyers and is given the fancy name of “earnings make good provisions.” In this approach, investors demand that a company’s CEO make personal guarantees, as well as on behalf of his company, that certain minimum net income targets will be met – typically for 3 years in a row from the date of the investment. If the company misses its earnings targets in a particular year, then the CEO could lose the majority control of his company to the investors in order to “make good” on the earnings promised. This financing mechanism is worse than a weather forecast, though. Unless one can predict weather conditions precisely on a specific date, for three years in a row, then one may lose control of his company. The mechanism not only spurs fraudulent behavior on the management side, but also limits the investing public’s upside; earlier investors often sell short against their positions.

Currently, previously entered “earnings make good provisions” related financing has led many China based, U.S. listed high growth small cap companies to trade at single digit current year multiples and left them highly vulnerable to short seller attacks. As a result, such companies are fighting short-sellers on a daily basis, literally. These “poison terms,” or “earnings make good provisions,” are a major complaint among Chinese business CEOs who have been duped by small investment banks. A willingness to do “whatever it takes” to meet consistently high earnings targets is not always a good thing, as we see here. It is fertile soil for fraudulent activity that leads to a high risk option for both the company involved and its public investors

Read more: Meet Benjamin Wey, CEO of New York Global Group, Journalist, Thought Leader

Source : Market Expert Benjamin Wey on Identifying Sound U.S. Listed Chines Companies